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Critical Topics and Their Significance for the UPSC CSE Examination on April 01, 2025

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The impacts of rupee weakening

For Preliminary Examination:  Current events of national and international importance

For Mains Examination: GS III - Indian Economy

Context:

The sharp devaluation of the Indian rupee is driven by capital outflows, higher import costs, and a policy shift by the RBI; structural issues such as rising domestic prices and real exchange rate appreciation further complicate the recovery of net exports

Read about:

Power Purchasing Parity (PPP)

Foreign Exchange Management Act (FEMA)

Key takeaways:

The Indian rupee has recently experienced a significant devaluation against the US dollar, following a period of relative stability for over two years. What are the underlying reasons for this shift, and what implications does it hold? This discussion explores India’s exchange rate policy and highlights key structural challenges within the Indian economy in recent years.

Exchange Rate Frameworks

The nominal exchange rate represents the cost of acquiring one unit of foreign currency in terms of the domestic currency. Changes in the nominal exchange rate are influenced by the interplay between supply and demand in the foreign exchange market and the central bank’s exchange rate policy.

The real exchange rate reflects the relative cost of foreign goods in terms of domestic goods, taking into account price levels. It indicates the comparative affordability of domestic goods against foreign ones.

The demand and supply in the foreign exchange market are shaped by the flows in the current and capital accounts. A decline in the combined net flows of these accounts increases the demand for foreign currency, while an increase in net flows boosts its supply. Net current account flows are largely determined by net exports, whereas capital account flows depend on foreign investment inflows and outflows. Reduced net exports and greater capital outflows increase the demand for foreign currency and vice versa.

Central bank responses to market conditions define three primary exchange rate regimes: fixed, floating, and managed-floating.

• Fixed Exchange Rate: The central bank offsets higher foreign currency demand by selling foreign exchange reserves to maintain a fixed nominal exchange rate.
• Floating Exchange Rate: The central bank allows the currency to devalue to meet increased foreign currency demand, keeping reserves unaffected.
• Managed-Floating Exchange Rate: The central bank combines selling reserves and allowing devaluation to address higher demand.

India has predominantly followed a managed-floating exchange rate system over the last three decades. In the 2010s, the Reserve Bank of India (RBI) adopted a nuanced approach under this regime.

During periods of excess demand, it devalued the rupee and reduced foreign exchange reserves. Conversely, during excess supply, the RBI resisted nominal exchange rate appreciation by accumulating reserves to safeguard export competitiveness. This asymmetric policy resulted in a gradual rupee devaluation throughout the decade.

Post-COVID, particularly between late 2022 and November 2024, the RBI temporarily adopted a policy resembling a fixed exchange rate regime, maintaining a stable nominal exchange rate despite current account deficits and capital outflows by selling foreign reserves. However, the recent sharp rupee devaluation suggests a return to the managed-floating